Tuesday, August 19, 2008

It may be time to pay up

I may need to take out a subscription to the FT, just so I can read more articles like this blog post by Martin Wolf.

He starts with the question:

What is the goal of the limited liability, joint-stock company, the core institution of the contemporary capitalist economy?

Back in school, I learnt that the goal is to maximize shareholder value. I remain convinced that this goal makes sense, but this piece has made me think. The mechanism which supposedly compels managers to maximize shareholder value is the market for corporate control, but what is the effect of such a market on behavior within a firm?

First, there may be some sense in which "firms" wish to maximize shareholder value, but people work for other reasons

Committed workers in successful companies do not work in order to maximize shareholder value or even to earn the largest possible living. Indeed, it is impossible to direct most companies solely by the goal of profit-maximization

If people are not willing to give their all for the shareholder, how can a firm get its employees to perform?

The salient characteristic of the contracts inside the firm (that is between the company, its employees and, quite often, its suppliers and even distributors) is that they are relational. That is to say, they cannot be written down in any precise form. Companies are hierarchies in which people engage voluntarily. They necessarily work on the basis of trust in what is often a very long-term relationship: I work extra hard to meet a deadline now, in return for consideration when I need to look after my elderly mother later on. For many companies, trustworthiness is an essential ingredient in their long-term success.

Knowing what an employee is capable of takes time - an employee who moves from job to job or firm to firm remains an unknown quantity - and performance usually requires you to work in a team. Simply increasing incentives may have perverse effects.

So what is the effect of an active market for corporate control on the "implicit contracts" within an organization?

if companies can be freely bought and sold, relational contracts, which depend on continuing interaction among specific people inside the business, are hardly worth the paper they are (not) written on. Rational employees will act opportunistically, because they will always expect their company to do the same. The longer and more reliable relationships are expected to be, the less likely such opportunistic behaviour is to emerge

Hence

capital-market arrangements (and associated views of the firm) that enforce shareholder value maximization may (I stress “may”) make companies work less efficiently than otherwise, in terms of their primary role, by precluding (or at least making far more difficult) a range of potentially valuable relational contracts inside the firm.

I wonder if there is something about the location of London- stuck between the US and Europe- which makes it less inclined to dogmatism than either.

Postscript: This is exactly why this, while fascinating, seems so Marxist. It hearkens back to a time when productivity was easy to measure because what was produced was tangible. and there were no long lead times between effort and output. Today, productivity is a much vaguer concept. If your designer or software developer is staring into space, he could be planning his next vacation or could be about to generate a breakthrough idea for you. Marx was a product of his time of "dark, satanic mills".

Today, Martin Wolf can argue that there is a perspective from which shareholders are not genuine owners because they do not bear the greatest part of the risks of running a business

They contribute nothing of value to the competitive strengths of the firm, enjoy the benefits of limited liability and are well able to diversify the risks they run. They are merely an (ever-shifting) group of people with a claim to the residual incomes. Those with the biggest (undiversifiable) investment in the firm -- and thus the greatest exposure to firm-specific risks -- are not shareholders, but core workers. The interests of the latter are, therefore, paramount

while Chris Dillow arguesbeautifully that employee-ownership is appropriate because employees control the one truly scarce resource. For bonus points, he also points out the conditions where co-ops may not make sense, and these include

physical capital-intensive firms where worker effort can be monitored. Here, the key to success is getting machinery to run well, rather than getting workers to do well. Car plants, for example, are better run by capitalists, not workers

An example of the benefits of knowing economics theory. Nuance comes easily.